In this third installment in our Mythbusters series (with credit to the Discovery Channel show, MythBusters), we turn to the oft-repeated but seldom-scrutinized notion that reporting values in financial statements creates volatility.This idea has been in the spotlight because of the recent financial crisis, with one myth-monger after another blaming the Financial Accounting Standards Board and anyone but themselves for financial institutions’ crashing stock prices. They say that mark-to-market accounting made it look like these entities were going into the tank. How much better it would be, they said, if the collateralized debt obligations were just carried at their cost so things wouldn’t look so bad. And if they didn’t look so bad, we’d all be better off.
The same whining about volatility occurs in other situations. Another example is found in accounting for defined-benefit pension and post-retirement plans, where buffers were built into GAAP to keep volatility out of statements from benefit amendments, changes in fair values of plan assets, and actuarial gains and losses. The rationale for hiding this information is that it prevents volatility that managers don’t want to report.
We also point to depreciation on tangible assets as a place where volatility is virtually eliminated by basing annual expense amounts on systematic allocations, instead of observations of real value changes. Reporting the same assumed amount of expense every year does indeed smooth out real variations that occur as the assets’ market values vary in response to supply and demand shifts.
In the 1990s, FASB proposed that marketable investments be carried at market with annual changes in value reported on the income statement.
In response to the clamor of bankers, the board backed off and created the available-for-sale, or AFS, portfolio that keeps volatility out of the statements by parking unrealized gains and losses on the balance sheet. (For an example of an AFS investment, see the table on page 16.)
According to myth-mongers, the AFS accounting system is preferable because it produces nonvolatile income. In contrast, they disdain mark-to-market because of the volatility from reporting the real gains and losses. Let’s look at that reasoning more carefully.
The myth is that using market values in financial statements creates volatility.
A Flaw No. 1: Because accounting is a record-keeping and reporting activity, it cannot create volatility. What actually creates the variability in the “real gain/loss column” is management’s decision to acquire and hold risky investments that produce variable returns from one period to the next.
To explain, risky investments are characterized by widely dispersed possible outcomes. Imagine a couple of bell-shaped curves representing those outcomes: Less risky investments have narrow distributions clustered around the mean, while more risky investments have flatter distributions with tails reaching out far in both directions.
The accounting issue is how to most usefully show that management decided to invest in riskier assets, instead of less risky ones. Because the difference between the two categories lies in the distribution of outcomes, then it follows that putting variable returns on income statements is surely a useful way to convey that exposure to risk.
The numbers in the example show that reporting the volatile real gains and losses in each year would reveal the consequences of investing with higher risk, instead of masking the variable returns by reporting no gains and losses.
A Flaw No. 2: The second flaw is like the first, but different. Because risky activities produce variable results, it follows that financial statements cannot be reliable if they mask that risk by concealing variable outcomes. What’s ironic is that defenders of the status quo argue that cost-based methods are more reliable than value-based ones, even though just the opposite is true.
Cost-based results cannot be reliable because they don’t faithfully represent the real economic events that are taking place. Instead of reporting what happened, they report as if nothing occurred.
The example shows what’s wrong with keeping gains and losses off income statements. For the five years in which the investment is held, the reported income under AFS doesn’t send clear signals about the variable annual returns from this risky investment. However, that stability is totally illusory. Then, when the investment is sold, the concealment method suddenly pumps up 2012 earnings by $35,000, despite the fact that the real gain in that year was only $2,000. Because it doesn’t report gains and losses when they actually occur, the method ends up reporting them when they did not occur. From the users’ point of view, nothing about these deliberately executed fabrications is reliable.
In effect, the allegedly conservative method ends up providing misleading information, all in the name of reliability and stability. Financial statement users should be shaking their heads in dismay, especially with the recent burst of public defenses of historical cost-based accounting because of its so-called “objectivity.”
Apparently those who offer these arguments do not realize that they are both specious and spurious. In fact, we think they are only carefully crafted rationalizations for auditors’ desires to lay low and take no chances. Unfortunately, they have been left unchallenged for so long that they are widely considered to be true.
The myth that using market values in financial statements creates volatility is: Busted! First, volatility results from taking risks, not from accounting methods. Second, reporting market values reveals volatility instead of concealing it.
When it comes to informing financial statement users and the capital markets, nothing works nearly as well as telling the truth, the whole truth, and nothing but the truth. As soon as someone messes with that concept by reporting what they wish were true but isn’t, the consequence is diminished usefulness (because the truth isn’t reported) and diminished credibility for all financial statement messages (because the truth isn’t reported).
So, we have busted yet another myth, along with these: Cost is a reliable depiction of fair value, market values are hypothetical numbers, and values are irrelevant for assets that aren’t going to be sold. We have another one waiting in the wings: Costs may not be relevant but at least they’re reliable.
Our ultimate objective in this series is to get people to come to grips with reality and start reflecting it in financial statements, instead of filling those documents with imaginary and deceptive numbers. Only when the truth is told (all of it) will anyone involved in accounting have a chance to live happily ever after.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at email@example.com.
Which is preferable?
A sample available-for-sale investment, bought in 2008 for $100,000, held until 2012 and sold for $135,000
Ending Real AFS
Year Value Gain/Loss Gain/Loss
2008 $120,000 $20,000 $0
2009 150,000 30,000 0
2010 110,000 (40,000) 0
2011 133,000 23,000 0
2012 135,000 2,000 35,000
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